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How Low Can Rates Go?

August 22, 1993

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HOW LOW CAN RATES GO?

It shouldn't have come as a surprise--though it did to many. No sooner had the vote been cast in Washington in favor of a historic budget-cutting agreement than the bond market opened with a rally, pushing the yield on the 30-year Treasury bond to a 16-year low of 6.44% by Aug. 10.

The market will give up some of its gains, but the trend is clear: Interest rates will ratchet downward for some months to come. In the 1980s, easy fiscal policy was offset by tight monetary policy. In the 1990s, the relationship may be reversed--fiscal drag could well be offset by lower rates.

The Clinton Administration bet that rates would fall when it pushed for the deficit reduction package, and it continues to hope for still lower rates as it tries to convince the public of the rightness of the new fiscal discipline. "I don't think there's any question that the fall in [long-term] rates in the last few days is due to passage of the deficit reduction package," says Robert E. Rubin, director of the White House National Economic Council.

The Clintonites seem likely to get their wish. Lower rates will prevail, not because the Federal Reserve Board ordains them or because the financial markets like them. Indeed, members of the Fed have recently sounded warnings about inflation, and the financial markets remain sensitized to the smallest hint of rising prices. If anything, the Fed and the markets have been slightly biased toward higher rates, not lower ones.

INFLATION MIRAGE. But the budget agreement ensures that what was sluggish growth is likely to remain so, even with the help of lower rates. Thus the mirage that held sway over the financial markets--the prospect of healthy economic recovery that might ignite inflation--has now truly vaporized. Throw in the harsh reality of recession or near-recession in all the major industrial nations, and the stage is set for still further declines in interest rates. "These lower rates have a lot of staying power," says economist David Resler of Nomura Securities International Inc. "There's no economic activity out there that would cause them to reverse course, and there should be continued downward pressure." Indeed, if the inflation rate keeps decelerating as it recently has (chart), there's room for the long bond to fall below 6% and even dip to 5 1/2% in coming months.

Lower rates may not be able to lift the U.S. economy above a growth path of 2 1/2% to 3%, but they will certainly be the tonic that prevents rising taxes and defense and Medicare spending cuts from pushing growth below that range. Expectations are that the budget agreement could shave a half-percentage point off gross domestic product growth next year. Cheaper money--especially the delayed impact of the rate decline that began in February--should work to offset a good part of that fiscal drag. On balance, though, it will be a considerable achievement to obtain growth of 2 1/2% just as serious deficit reduction begins.

There may be other benefits that kick in only later, enhancing growth after this year. One is that companies have been able to refinance their debt at lower rates, and that has put them in a better position to ramp up spending and production if demand picks up steam. Then, too, lower rates have restored a measure of financial health to the banking system, which was flirting with a 1930s-style collapse only a few years ago. So when growth revives, banks will be in a better position to meet rising loan demand. Finally, higher marginal tax rates and falling yields may make state and local securities more attractive, providing the public sector with new opportunities to finance infrastructure spending. Such spending could give oomph to the economy, perhaps next year and into 1995.

The boost only goes so far, though. Despite the hoopla that would have us celebrating the lowest rates in years, rates in real or inflation-adjusted terms are not so low as they seem. After subtracting inflation of about 2 1/2%, medium- and long-term interest rates still range from 3 1/4% to 4% in real terms. That may explain why the economy's response to falling rates so far this year, while positive, hasn't been dramatic.

LIGHTER BURDENS. This suggests that housing, auto sales, and investment, which typically thrive with declining rates, will do so once more--but not spectacularly, unless real rates start to fall as well. These three interest-sensitive sectors, which generally propel economic recovery, indeed have been doing better in recent months. But the gains have been steady and gradual and are likely to remain so. No fireworks here.Mortgage refinancings, for instance, now account for a hefty 55% of all mortgage application volume after a second spurt this year (chart). If rates keep falling, another round of refinancing is bound to occur. Household debt burdens will get lighter, and cash flow will be freed up. Ideally, then, there will be more spending on home improvement, appliances, furniture, and other goods. "People will feel more comfortable spending on their homes," says Roger Kubarych, economist at Henry Kaufman & Co. And an improving housing resale market will mean that "they feel they're investing in an appreciating rather than a depreciating asset."

Likewise, the homebuilding market is getting a boost, but so far only a small one. Housing starts are up an annualized 3%, to 1.25 million units, so far this year. But that remains well short of the 1.5 million annual units of the 1980s and 1.8 million units of the 1970s. Part of that has to do with demographics--household formation has slowed down. But economists also believe that it will take a bigger break in rates to really rev up the housing construction market.

GRADUALIST GAME. Auto sales, too, are improving, thanks in part to lower rates. Car and light truck sales are running at a 13.6 million annual rate so far this year, up 6% from last year. But that's below 1990's 13.9 million pace and 1989's 14.6 million units sold. Business investment has been concentrated in equipment, and here, lower rates have clearly made spending more attractive--pushing expenditures up at a 14.7% rate in real terms over the past year. But unless U.S. manufacturers enjoy the follow-through of rising and healthy demand for their products, capital spending gains will slow.

Much of what happens next depends on the rest of the world. Following the near breakup of the European Monetary System, rates should begin to fall across the Continent as government officials, freed from following Germany's tough money policy, pursue domestic economic objectives and try to revive growth. European currencies may weaken against the dollar as a result, a development that would give Europe a trade advantage. But the effect of cheaper money in boosting demand for goods could overwhelm that advantage and allow the U.S. to export more to Europe. And sliding European rates could, in turn, permit U.S. rates to fall further.

How much good will lower rates do the economy in the end? There's no doubt the effect will be positive. But after 12 years of steadily falling rates, it's not clear that a few more turns of the screw will make a huge difference for growth. And if lower rates only ensure growth of 2 1/2% for the foreseeable future, it could take a long time to bring the unemployment rate down markedly from its current 6.8%. These days, gradualism is the name of the game. It yields a steady but halting improvement in the economy--hardly the one Americans are accustomed to, but far from the worst possible outcome.Karen Pennar in New York, with Christopher Farrell, and Owen Ullman in Washington